People ask us a lot about borrowing from their 401(k): “Why would I want to borrow from banks and pay them interest when I can just borrow from myself?!” Well, it’s more complicated than that. It is true that if your 401(k) plan allows it and if you are fully vested, you may borrow from your own account. But like everything else in the world, nothing is free. First, you need to pay it back with interest, and the payments are not deductible as interest payments or contributions. Second, for most plans, your employer will cease all contribution matches until you pay the loan back. Not only are you losing out on free money from your employer, but you are also missing the investment earnings from the market. Third, if you leave your job before you are able to pay the loan back, you will be forced to either pay back the entire amount in one go, or consider the loan as a distribution. That means, if you are younger than 59 ½ years old, you will be hit with a penalty on top of ordinary income taxes. Tim gave a great example of how you may lose $450,000 in 25 years from a small $50,000 loan even if you pay it back within 5 years. Oh man, that hurts! Overall, please remember, a 401(k) is not designed to be borrowed against - it is meant to be a long-term investment vehicle for your retirement. There are better borrowing alternatives out there.
